'Low Cost' ETFs Actually Cost Investors More Than Some Hedge Funds

ETFs bill themselves as low-cost alternatives to standard mutual funds or even hedge funds. The idea is that their management fees are lower and trading costs are low since you can simply buy and sell them easily through a discount online broker.

But here's the problem -- it's only true if ETFs are actually tracking their benchmarks effectively. Unfortunately they aren't.

In 2009, ETFs missed their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008, according to a study of ETF returns released this week by Morgan Stanley.

Part of this so-called tracking error stems from the recent proliferation of ETFs targeting exotic investments or areas where trading is less frequent, such as emerging-market stocks and junk bonds.

Last year, 54 ETFs showed tracking errors of more than three percentage points, up from just four funds the prior year. And a handful of the 54 missed by more than 10 percentage points.

1.25% is more than the management expense of some actively managed funds, or some hedge funds even (before performance fees).

We think ETFs are great for tracking broad, liquid benchmarks such as the S&P 500 where they are likely to be worthwhile in terms of cost and trading ease. But ETF products for niche investments are highly suspect. The more illiquid investments the worse off ETF investors will be, especially since savvy traders will likely be able to line up and pick-off trades ahead of the ETF.

For anything niche, investors are probably better off with old fashioned mutual funds once all of their real expenses are factored in.

Yet we're fully aware of the fact that expenses of an ETF such as the above are near-invisible, especially if someone is been trading in and out of an ETF. So we'll expect investors to keep lapping these products up. In investment management, products with the least visible expenses, and best ability to avoid blame, win.